Editor's note: Our three-part series this week on what to look for in financial advice, by Morningstar contributor David Aston, continues today with a detailed look at mutual-fund dealers and robo-advisors, the most accessible advice-givers for small investors. The series began on Monday and concludes on Friday.
Small investors have traditionally had limited choice for investing with an advisor. While mutual funds have been criticized for high fees, that was often the only way to go if you didn't have much money and wanted to work with an advisor. However, new options are emerging. In particular, robo-advisors offer a way to invest wisely with lower fees and limited advice. Now robo-advisors are showing signs of evolving to create new low-cost models with more extensive advice.
The largest group of advisors who are licensed to sell investment products are the 82,900 mutual-fund representatives. They sell mutual funds on a non-discretionary basis, but can't sell individual securities like stocks and bonds, and very few are able to sell exchange-traded funds. They work in bank branches, with insurance company-owned mutual-fund dealers, or with independent mutual-fund dealers, and they generally advise investors with small- and medium-sized accounts. Many of them -- especially those that work for insurance companies -- also have an insurance licence that permits them to sell insurance products, including annuities and segregated funds. Mutual-fund advisors are self-regulated by the Mutual Fund Dealers Association, subject to oversight by provincial regulators.
The requirements to be licensed to sell mutual funds are fairly basic, but many fund advisors have financial-planning designations. If you have at least $100,000 to invest, you should be able to find good choices for establishing a relationship with a qualified advisor. However, if you have less than $100,000, finding that relationship is liable to be hit or miss. That's because many of the advisors with the higher-level investment credentials in bank branches and elsewhere "are hunting for clients with between $100,000 and $500,000 in investable assets," explains Keith Sjogren, managing director of consulting services at Investor Economics.
If you have smaller sums, you can of course still buy mutual funds, but you may have difficulty finding the same level of advice. In many cases, you're liable to be steered toward mutual funds in "portfolio solutions" offered by most of the major institutions. These are pre-packaged but professionally constructed portfolios of individual mutual funds that can be more efficiently sold by staff who lack the time or skills required to construct customized portfolios. The portfolio components are rebalanced automatically. Often the fees are no more than you would pay if you bought the funds individually from an advisor.
What you pay: The management-expense ratios (MERs) for a balanced portfolio of mutual funds are typically about 2% per year. The trailer commissions that go to the advisor and the advisor's company are typically a little less than half that total. Lack of transparency on trailer fees has been heavily criticized and was a major catalyst for the recent initiative by Canadian securities regulators to require more transparent reporting of advisor fees under an initiative known as CRM2. Along with collecting trailer commissions, some dealers may also charge front-end loads, or in the case of the deferred-sales-charge option, investors may be subject to redemption fees.
What to look for or avoid: Mutual funds have traditionally been the only major channel whereby smaller investors can get access to full-service financial advice, although advice is liable to be limited for the smallest accounts. While qualifications vary, look for fund advisors who hold the designation of certified financial planner (CFP) or personal financial planner (PFP).
With mutual funds charging relatively high fees as a percentage of assets, many investors find they "outgrow" mutual funds when their account balances become large enough to attract other types of advisors like brokers and investment counsellors, who tend to cost less in total fees on a percent of assets basis. For small investors who are satisfied with limited advice, robo-advisors provide a cheaper option.
An obviously beneficial option would be for fund advisors to sell low-cost passive ETFs alongside mutual funds, but they have been effectively precluded from doing so with rare exceptions. While there is no rule that says mutual-fund dealers can't offer ETFs, there are immense practical barriers from having different transactions, self-regulatory regimes, compliance requirements, systems and training. Advisors under the purview of the Mutual Fund Dealers Association (MFDA) "have been handcuffed when it comes to passive solutions," says Chuck Grace, a lecturer at Western University's Ivey Business School, industry consultant and former chief operating officer at Quadrus Investment Services Ltd., a mutual-fund dealer with more than 3,700 licensed representatives. "Most investors would have a more optimized portfolio if they had a combination of active and passive investments."
Robo-advisors simplify investing
Robo-advisors provide an investment approach based largely on online access and contact. They automate and simplify investment processes where skilled human assistance isn't considered essential, and they use low-cost ETFs as the investment building blocks. They also generally provide access to a qualified financial advisor by phone, email or text where there is a particular need, but human access is limited. Their approach is essentially discretionary, where you agree on the portfolio design up front, and they manage it on a day-to-day basis after that. The robo-advisor ranks include small independent firms, but an increasing number are either owned or have other tie-ins with major financial institutions.
While advisor contact is limited, many advisors are well qualified and have high- level credentials such as the chartered investment manager (CIM) or chartered financial analyst (CFA) designations.
What you pay: Fees vary based on the size of your investment. If you have $50,000 to invest, robo-advisors typically charge 0.5% to 0.7% of assets per year. With ETF MERs on top of that, total fees usually come in a bit under 1%. So generally they're around half the cost or a bit less compared to mutual funds that come with full-service advice.
What to look for or avoid: Robo-advisors provide a solution for anyone who doesn't need a lot of human advice and who is content turning over day-to-day management of their investments to a proven, low-fee passive approach. It is liable to work particularly well for small investors with limited choices.
For now, robo-advisors don't generally provide much human support, so for the most part are not well suited to investors who need full-service advice or want a strong advisory relationship. However, robo-advisors are starting to expand the human-advice side of their offerings and thus evolve to compete more directly with full-service advisors. For example, WealthBar provides some basic automated financial-planning assistance. Wealthsimple also offers a service called Wealthsimple Black, which offers a little more extensive assistance at a slightly lower fee for investors with $100,000 and up.
But the most intriguing innovation may be the marriage of robo-advisor platforms with full-service financial-planning advice by external providers. Both Nest Wealth and Wealthsimple have developed versions of their platforms to support this. In the case of Wealthsimple for Advisors, the robo-advisor manages the investments, allowing the advisor to concentrate on financial planning or other areas of advice. "We believe in the value of advice," says Michael Katchen, CEO of Wealthsimple. "We just think great technology can make that even more enhanced."
Wealthsimple charges 0.35% for managing the portfolio and the advisor can charge up to an additional 1.15% for their services. That provides the potential to offer full-service financial advice with investment management for even small accounts at a total cost of no more than 1.5% of assets per year, significantly less than the MERs of a balanced portfolio of mutual funds with full-service advice.
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